And, as I said, this was not just a U.S. situation. The U.S. recession was, in fact, a rather average recession. Many countries around the world had worse declines, particularly those dependent on international trade. So it was a global slowdown. And as all this was happening, fears of another Great Depression were very real. Nevertheless, the Great Depression was much worse than the recent recession. And I think the view is increasingly gaining acceptance that without the forceful policy response that stabilized the financial system in 2008 and early 2009, we could have had a much worse outcome in the economy.
I will close with a couple of indicators to compare the recent recession with the Great Depression. First, Figure 28 shows the stock market. The darker line starts in August 1929, which was the peak of the stock market before the Great Depression. The lighter line shows the more recent stock prices, starting in October 2007. And then each of the graphs shows you the evolution of stock prices in the Depression period and in the more recent period. What is striking is that for the first fifteen or sixteen months, stock prices in the United States behaved in this crisis very much as they did in 1929 and 1930. But about fifteen or sixteen months into the recent crisis, in early 2009, about the time that the financial crisis was stabilizing, look what happened. In the Depression era, stock prices kept falling and, as I mentioned, in the end stock prices lost 85 percent of their value. In the recent crisis, by contrast, U.S. stock prices recovered and began a long recovery, and they now are more than double where they were three years ago.
Figure 28. S&P 500 Composite Index for Up to 95 Months since Peak, 1929 versus 2007
Figure 29 shows industrial production, a measure of output. Again, the lighter line graphs the more recent data. The darker line graphs the Depression-era data. You can see that in this recent crisis the fall in industrial production was not quite as severe or as fast as in the Depression. But you get the same basic phenomenon that about fifteen to sixteen months into the episode, about the time that the financial crisis was brought under control, industrial production bottomed out and began a period of steady recovery, whereas in the Depression, the collapse continued for several more years.
STUDENT: In both this lecture and the previous one, you mentioned the increasing issuance of exotic and subprime mortgages. Why are financial institutions willing to bear so much risk to lend even to borrowers with poor credit? And if they had foreseen the decreasing prices in the housing market, would they still have made those loans?
Figure 29. Industrial Production for Up to 95 Months since Peak, 1929 versus 2007
Source: Federal Reserve Board
CHAIRMAN BERNANKE: There were a couple of reasons. One was simply the fact that firms were probably too confident about house price increases and said, “Well, house prices are likely to keep rising.” And in a world in which house prices are rising, these are not such bad products because people can afford to pay for a year but then they can refinance to something more stable, and this may be a way to get people into housing. But the risk was that house prices would not keep rising, and of course that is ultimately what happened.
The second reason was that the demand for securitized products grew very substantially during this period. In part, there was a large international demand from Europe and from Asia for high-quality assets, and always-clever U.S. financial firms figured out that they could take a variety of different kinds of underlying assets, whether subprime mortgages or whatever, and through the miracle of financial engineering they could create from them at least some securities that would be rated triple-A, which they could then sell abroad to other investors. Unfortunately, that sometimes left them with the remaining bad pieces, which they kept or sold to some other financial firm.
So there were trends in the financial markets, including overconfidence about their ability to manage those risks; a belief that house prices would probably keep rising; a sense that after they made those mortgages, they could sell them to somebody else and that other investor would be willing to acquire them; a big demand for “safe assets.” For all those reasons, it was actually a very profitable activity while it lasted. It was only when house prices began to fall that it became a big loser.
STUDENT: You were talking about how one of the major things the Fed had to do was figure out how to get liquidity flowing again in the market. That reminds me of the Volcker Rule because, as I understand it, the Volcker Rule bans proprietary trading by investment banks, but it also left gray areas for principal trades, which, as I understand, are very important for market makers to create markets and find liquidity. So I wonder what you think about that. Doesn’t that seem rather counterintuitive?
CHAIRMAN BERNANKE: Well, the Volcker Rule is a part of the Dodd-Frank financial regulatory reform, which the Fed and other agencies are tasked with implementing. The purpose of the Volcker Rule, as you said, is to reduce the risk of financial institutions by preventing banks and their affiliates from doing proprietary trading, which means doing short-term trading on their own accounts.
The Dodd-Frank law recognizes that there are legitimate reasons that banks might want to acquire short-term securities and it makes certain exceptions for them. They include, for example, hedging against risk. But one particular exception is to make markets, to serve as intermediaries who buy and sell in order to create liquidity in a particular market—that is exempted from the Volcker Rule. One of the challenges of implementing this rule is trying to figure out how to create a set of standards that allows the so-called exempted or legitimate activities, such as market making and hedging, while ruling out proprietary trading. That is very difficult, and we are working on that. We put out a rule and we have gotten thousands of comments, which we are looking at to figure out how best to do that.
But the point you raised is that liquidity in markets is important. During the crisis, it was a much worse problem than just a lack of trading volume. You had big financial institutions unable to find the funding to support their asset positions, which left them with two possibilities: either defaulting because they do not have enough funding, or (the tack that many of them took) selling off assets as quickly as possible, which in turn spreads panic. Because if there is a huge seller’s market for, say, commercial real estate bonds, that is going to drive the price down very sharply. And then any company that is holding those bonds finds its financial position being eroded and that creates pressure on it.
I did not use the word contagion in my discussion. A contagion, just as in an illness context, is the spreading of panic, the spreading of fear from one market or institution to another. Contagion has been a major problem in many financial panics, and certainly in this one. That was one of the mechanisms that caused funding pressures to jump from firm to firm and created such a broad-based problem.
STUDENT: I have a question about global collaboration during the financial crisis. You talked about the G7 in 2008. Specifically, as we saw multinational corporations begin to be on the brink of failure, what pressures came from the international community when the decision to, say, bail out AIG was being debated?
CHAIRMAN BERNANKE: Well, there weren’t any real pressures. Everything was happening too fast. I think one area where collaboration was not as good as we would like was in dealing with some of these multinational firms. For example, there were problems between the United Kingdom and the United States over the failure of Lehman Brothers, and inconsistencies that caused problems for some of Lehman’s creditors.
So one of the things we are trying to do under the Dodd-Frank financial reform legislation, as I mentioned before, is to create provisions for safely allowing large financial firms to fail. But one of the complexities is that many of the firms that this would be applied to are multinational firms, operating not just in two or three countries but maybe in dozens of countries. And so, we are collaborating with other countries in figuring out how we would work together to help a large multinational firm fail as safely as possible. We tried during the crisis to cooperate in mostly
ad hoc ways, and we were in touch with regulators in the United Kingdom and elsewhere. But, given the time frame and the lack of preparation, we did not do as much as we would have been able to do with more lead time. So I think that was a weakness of international collaboration.
For the most part, though, countries cooperated in dealing with the financial institutions that were based in their own countries. AIG was an American company, and we dealt with that, whereas Dexia, which was a European company, was dealt with by the Europeans. Also, there was a lot of cooperation between central banks. A lot of European banks needed dollar funding as opposed to euro funding. They use dollar funding because they hold dollar assets and they make loans to support trade, which is often done in dollars, so they needed dollars. The European Central Bank cannot provide dollars. So we did what was called a swap, where we gave the European Central Bank dollars and they gave us euros. They took the dollars we gave them and lent them on their own recognizance to European banks, easing dollar funding pressures around the world. So, those swaps, which are still in existence because of the recent issues in Europe, were an important example of collaboration. Also, in October 2008, right as this crisis was intensifying, the Federal Reserve and five other central banks all announced interest rate cuts on the same day. So we coordinated even our monetary policy. There were some areas, such as multinational firms, where a lot more preparation was needed and we are still working on those things cooperatively today.
STUDENT: Could you elaborate on the off-balance-sheet vehicles that were being used and why banks were allowed to keep that much information off their books?
CHAIRMAN BERNANKE: It has to do with accounting rules, basically. You create this separate vehicle, and the bank might have substantial interest in that vehicle. It might, for example, have a partial ownership. It might have some promises to provide credit support if it goes bad or liquidity support if it needs cash. But under the rules that existed at that time, if the amount of control that the bank had on this off-balance-sheet vehicle was sufficiently limited, then according to the accounting rules, the bank could treat it as a separate organization, not part of the bank’s own balance sheet. That allowed the banks to get away with holding somewhat less capital reserves, for example, than they would have had to carry if all these assets were on their own balance sheets.
One of the many good developments since the crisis is that these rules have been reworked, and many of the off-balance-sheet vehicles that existed before the crisis would no longer be allowed. They would have to be consolidated, which means they would have to be made part of the bank’s balance sheet, have appropriate capital reserves, and so on. So those practices are not completely gone, but the accounting rules have greatly tightened the situations and circumstances under which a bank can put something off its balance sheet into a separate investment vehicle.
STUDENT: You mentioned several large firms that came under pressure in 2008 and also the Fed’s doctrine, if you will, of “too big to fail.” Where do you draw the line between bailing out a bank and allowing it to fail? Is it arbitrary or is there some sort of methodology that the Fed goes by?
CHAIRMAN BERNANKE: This is a great question. First, I want to resist the word doctrine. These firms proved to be too big to fail in the context of a global financial crisis. That was a judgment we made at the time based on their size, their complexity, their interconnectedness, and so on. It was not something that we ever thought was a good thing. Again, one of the main goals of the financial reform is to get rid of “too big to fail” because it is bad for the system. It is bad for the firms. It is unfair in many ways, and it would be a great accomplishment to get rid of “too big to fail.” So it was not something that we advocated or supported in any way. We were just in a situation where we were forced to choose the least bad of a number of different options.
During the crisis, we had to make judgments on a case-by-case basis, and we were trying to be as conservative as possible. In the case of AIG, there was really not much doubt in our minds. This was a case where action was necessary, if at all possible. Lehman Brothers was itself probably “too big to fail,” in the sense that its failure had enormous negative impacts on the global financial system. But there we were helpless because it was essentially an insolvent firm. It did not have enough collateral to borrow from the Fed. We cannot put capital into a firm that is insolvent. This was before the Troubled Asset Relief Program (TARP), which provided capital that the Treasury could use. So we had no legal way to save Lehman Brothers. I think if we could have avoided letting it fail, we would have done so. In the two cases where we intervened, Bear Stearns and AIG, the judgment was pretty clear, given not only the firms themselves but also the environment at the time.
Now interestingly, we have had to get much more into this issue since the crisis because there are a number of different rules and regulations that actually require the Fed and other regulatory agencies to make some determination about how systemically critical a firm is. For example, the new Basel 3 capital requirements require the largest, most systemically critical firms to have a capital surcharge. They have to hold more capital than firms that are not as systemically critical. As part of that process, the international bank regulators have worked together to set up criteria relating to size, complexity, interconnectedness, derivatives, and a whole bunch of other criteria that help determine how much extra capital these large firms have to hold. Likewise, the Fed, when it considers a proposed merger of two banks, now has to evaluate whether the merger would create a systemically more dangerous situation. So we have worked hard, and we have put out a variety of criteria including some numerical thresholds that we look at to try to figure out if a merger creates a systemically critical firm, and if it does, we are not supposed to allow that merger to happen.
So, the science of doing this is progressing. It is still in its infancy. But we are looking very seriously at this and, indeed, now that the Fed has become much more focused on financial stability, we have a whole division of people working on various metrics and indicators to try to identify risks to the system and firms that need to be particularly carefully supervised and maybe required to hold extra capital because of the potential risk they pose to the system.
STUDENT: One vulnerability that you mentioned was that the credit-rating agencies were assigning triple-A ratings to securities that carried much more risk than perhaps a triple-A rating might warrant. It seems as though the incentives would be aligned for the buyers to seek out ratings that were more accurate because they would be taking on more risk. Was there a systemic problem as far as how incentives were aligned within the credit-ratings system that allowed these faulty ratings to propagate throughout the system?
CHAIRMAN BERNANKE: Yes, there were some incentive problems, and you identify one of them, which is that, instead of the seller of the security being the one who hires and pays the credit rater, you would think that it would be in the interest of the buyers, who after all are the ones bearing the risk, to band together and pay the credit rater to give them the best opinion they can about what the credit quality is of the security.
Unfortunately, that model does not seem to work. The problem is what economists call a free-rider problem. Basically, if five investors get together and pay Standard and Poor’s to rate a particular issuance, unless they can keep that completely secret, anybody else can find out what the rating was and take advantage of that without being part of the consortium that paid.
So there have been a lot of ideas out there about how you can restructure the payment system to create better incentives for credit raters. But it is a challenging problem because, again, the “obvious solution” of having the investors pay only works if the investors collectively can share the cost and somehow keep that information from being spread among other investors.
LECTURE 4
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The Aftermath of the Crisis
Today I want to talk about the aftermath of the crisis. To recap, I talked la
st time about the most intense phase of the crisis, in late 2008 and early 2009: financial panic both in United States and in other industrialized countries; the threat to the stability of the entire global financial system; the Federal Reserve in its lender of last resort role, working with others, provided short-term liquidity to help stabilize key institutions and markets.
One of the conclusions we can now draw, having looked at the history, is that rather than being some ad hoc and unprecedented set of actions, the Fed’s response was very much in keeping with the historic role of central banks, which is to provide lender of last resort facilities in order to calm a panic. What was different about this crisis was that the institutional structure was different. It was not banks and depositors; it was broker-dealers and repo markets, money market funds and commercial paper. But the basic idea of providing short-term liquidity in order to stem a panic was very much what Bagehot envisioned when he wrote Lombard Street in 1873.
I have been focusing on the Fed’s actions, but the Fed did not work alone. We worked in close coordination with other U.S. authorities and foreign authorities. For example, the Treasury was engaged after the Congress approved the so-called TARP legislation. The Treasury was in charge of making sure that banks had sufficient capital and the U.S. government took an ownership position in many banks that was essentially temporary. Most of those have now been reversed. The FDIC played an important role. In particular, the $250,000 deposit insurance limits were raised essentially to infinity for transaction accounts. And the FDIC also provided guarantees to banks that wanted to issue corporate paper of up to three years’ maturity in the marketplace. For a fee, the FDIC guaranteed those issuances so that banks could get longer-term funding. So this was a collaborative effort between the Fed and other U.S. agencies.
The Federal Reserve and the Financial Crisis Page 9